“Measuring the Effects of Lean Manufacturing Systems on Financial Accounting Metrics Using Data Envelopment Analysis” David T. Boyd AUTHORS Larry A. Kronk Sanithia C. Boyd David T. Boyd, Larry A. Kronk and Sanithia C. Boyd (2006). Measuring the ARTICLE INFO Effects of Lean Manufacturing Systems on Financial Accounting Metrics Using Data Envelopment Analysis. Investment Management and Financial Innovations, 3(4) RELEASED ON Friday, 15 December 2006 JOURNAL "Investment Management and Financial Innovations" FOUNDER LLC “Consulting Publishing Company “Business Perspectives” NUMBER OF REFERENCES NUMBER OF FIGURES NUMBER OF TABLES 0 0 0 © The author(s) 2021. This publication is an open access article. businessperspectives.org 40 Investment Management and Financial Innovations, Volume 3, Issue 4, 2006 MEASURING THE EFFECTS OF LEAN MANUFACTURING SYSTEMS ON FINANCIAL ACCOUNTING METRICS USING DATA ENVELOPMENT ANALYSIS David T. Boyd*, Larry A. Kronk**, Sanithia C. Boyd***, Abstract Just-in-Time (JIT) manufacturing, also known as Lean Manufacturing, provides a strategy by which firms may improve their financial performance. Which indicators, in the form of conven- tional ratios derived from a firm’s financial statements, are truly made more favorable as a result of lean manufacturing systems is well documented. However, the use of conventional financial ratios, as input into parametric test procedures intended to highlight changes in manufacturing per- formance, may limit the extent of the analysis, and assumes the ratios are constructed from multi- variate normal distributions. This study examines the effect of lean manufacturing implementation on the financial performance of 18 different firms using a technique referred to as data envelop- ment analysis (DEA). DEA is a linear programming technique that allows assessment of the effi- ciency of an operating unit, and may be a useful alternative to conventional ratio analysis due to its affording simultaneous examination of multiple inputs and outputs. The analyses include signifi- cance testing of DEA performance rating changes as a result of lean manufacturing implementa- tion, a comparison of the implications of the DEA output to that of corresponding financial ratios, and tests for normality of the parameters studied. Key words: Data Envelopment Analysis; DEA; Just-in-time; JIT; Lean Manufacturing. JEL classification: M11. Introduction Since the 1970's, the just-in-time (JIT) philosophy, also referred to as lean manufacturing, has been utilized in manufacturing to varying degrees and with mixed financial results. Successful implementation of JIT is expected to lead to lower inventory carrying costs, increased utilization of operational assets, increased responsiveness to customer needs, and improved product quality. Incon- clusive assessments, among similar firms, of the financial benefits of lean systems may result from the dispersion of the degree to which JIT has been adopted, from that of simple inventory reduction to incorporation of the entire lean manufacturing philosophy and infrastructure. Sakakibara et al. (1997) determined that JIT practices have less of an impact on a firm’s performance than the infra- structure needed to achieve the lower levels of work-in-process (WIP) inventory. Taiichi Ohno, the executive who streamlined Toyota’s process, considered JIT and the supporting infrastructure to be a single lean system, defining waste as anything that does not contribute to the value of the customers’ product, including costly inventory. When identifying value, one must consider the entire fulfillment process, including the problem-solving function, from design through engineering to launch; infor- mation management, from order-taking through detailed scheduling to delivery; and the physical transformation task, converting raw materials to a finished product in the hands of the customer (Womack and Jones, 1996). Thus, lean systems confined to mere inventory reduction may fail, for example, due to the inability of the supply base to respond, the lack of a quality function sufficient to impart corrective action obviated by decreased inventory levels, or the lack of a structured mainte- nance program to ensure machine uptime once covered by inventory buffers. In addition to the varied degree to which lean manufacturing practices have been imple- mented, the corporate efficiency improvements and subsequent financial gains resulting from lean * Jacksonville University, USA. ** Thomas & Betts Corporation, USA. *** Jacksonville University, USA. © David T. Boyd, Larry A. Kronk, Sanithia C. Boyd, 2006 Investment Management and Financial Innovations, Volume 3, Issue 4, 2006 41 systems, as measured by conventional financial accounting ratios, may be clouded by the limita- tions of the ratios themselves. These ratios are normally expressed as some output per unit of in- put, such that the output may be adjusted for the size of the firm. However, the outputs, or numera- tors, may not exhibit proportionality over the range of the inputs (denominators) used. Further- more, many financial ratios are related in such a way that an improvement in one ratio comes at the expense of another. Finally, the comparison of financial ratios often involves the use of pa- rameters that erroneously assume multivariate normality. This paper is intended to examine the effect of lean systems on the performance of 18 companies from 7 different three-digit SIC codes, using information from the firms’ financial statements during the period from 1989 to 1998. During the given time period, the study focuses on the lean systems implementation year, referred to as the adoption year, the two years preceding the adoption year, and three years post-adoption. Specifically, the characteristics of the distribu- tions of the firms’ financial ratios, such as the return on assets (ROA), asset turnover (ATO), in- ventory turnover (ITO), labor utilization (LUT) and the cash return on assets (CROA), are evalu- ated, and trends in the operational performance as indicated by the ratios, resulting from lean im- plementation, are assessed. Additionally, the financial inputs and outputs that comprise these ratios were studied using a non-parametric technique referred to as data envelopment analysis (DEA). DEA generates an efficient frontier composed of linear combinations of the inputs and outputs of each decision-making unit (DMU) being studied. DMUs not found on this efficient frontier are deemed relatively inefficient, and the magnitude of the slack encountered in the subsequent sensi- tivity analysis provides insight into the resources that are being inefficiently consumed (Charnes et al., 1978). Thus, DEA, as applied to financial statement analysis, provides a scalar measure of overall financial performance while using multiple input and output variables, allowing simultane- ous assessment of many ratios (Charnes and Cooper, 1985). This study highlights differences in the DEA efficiency measures over the period studied to determine the statistical significance of improvements in operational efficiency resulting from JIT adoption. A review of the literature con- taining various evaluations of lean systems using conventional ratios is presented, followed by overviews of ratio analyses and DEA. The specific techniques employed in this study are then de- scribed, followed by a presentation of the results and conclusions. The Effect of JIT on Firm Performance: Previous Research JIT production methods generally lead to greater operational flexibility, improved quality, and lead time reductions. Because JIT and lean manufacturing systems focus on allowing the cus- tomer to “pull” material through the process, only replenishing inventories upon receipt of an or- der, the impact of such systems should be manifest in the inventory and asset turnover metrics. If the reduction in assets and improved efficiency reduces overall costs, then there should be a sub- sequent increase in the firm’s return on assets. As resources are freed by the elimination of non- value-added activities, productivity is expected to rise, as should labor utilization. It is reasonable to expect that reductions in accounts receivable and inventory, along with increases in productiv- ity, will also positively impact cash flow from operations, making the firm a more efficient con- verter of resources to cash. Great is the volume of studies that have been performed to assess the effect of lean systems on the financial health and productivity of various industries, and varied are both the analytical approaches taken and the results obtained. Balakrishnan et al. (1996), testing the significance of changes in median ROA, for pre- adoption vs. post-adoption JIT and non-treatment control firms, found that the ROA actually de- creased after inventory management systems were implemented, as did the ROA of control firms. Testing the magnitude of the ROA decrease for treatment versus non-treatment firms yielded no significant differences. However, the ROA decrease was significantly less for firms with non- concentrated customer bases, i.e., those not required to pass on JIT-related savings to their cus- tomers. Furthermore, firms that showed higher depreciation-to-cost ratios upon lean implementa- tion, indicating a larger investment in JIT, did not exhibit a significant dilution of the savings from lean manufacturing adoption by the higher committed costs. 42 Investment Management and Financial Innovations, Volume 3, Issue 4, 2006 Kinney and Wempe (2002) re-examined the